About ten years ago I published an article in Foreign Policy that I just recently re-read. In the article I extended one of the arguments I made in my book, The Volatility Machine, that the globalization process is driven primarily by monetary expansion and the consequent increase in risk appetite. What was new in this piece, because I hadn’t realized it when I wrote my book, is that every period of globalization coincided with a stage of the industrial revolution in which accompanying the expansion in international trade and capital flows is a major technological boom, driven also by monetary expansion.
After re-reading the article I thought it might be useful to republish it on my blog with a couple of comments while waiting for the next entry (which should come out this week). I think the point it makes about the process in which globalization is reversed is still worth considering.
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Will Globalization Go Bankrupt?
“Only the young generation which has had a college education is capable of comprehending the exigencies of the times,” wrote Alphonse, a third-generation Rothschild, in a letter to a family member in 1865. At the time the world was in the midst of a technological boom that seemed to be changing the globe beyond recognition, and certainly beyond the ability of his elders to understand. As part of that boom, capital flowed into remote corners of the earth, dragging isolated societies into modernity. Progress seemed unstoppable.
Eight years later, however, markets around the world collapsed. Suddenly, investors turned away from foreign adventures and new technologies. In the depression that ensued, many of the changes eagerly embraced by the educated young — free markets, deregulated banks, immigration — seemed too painful to continue. The process of globalization, it seems, was neither inevitable nor irreversible.
What today we call economic globalization — a combination of rapid technological progress, large-scale capital flows, and burgeoning international trade — has happened many times before in the last 200 years. During each of these periods (including our own), engineers and entrepreneurs became folk heroes and made vast fortunes while transforming the world around them. They exploited scientific advances, applied a succession of innovations to older discoveries, and spread the commercial application of these technologies throughout the developed world. Communications and transportation were usually among the most affected areas, with each technological surge causing the globe to “shrink” further.
But in spite of the enthusiasm for science that accompanied each wave of globalization, as a historical rule it was primarily commerce and finance that drove globalization, not science or technology, and certainly not politics or culture. It is no accident that each of the major periods of technological progress coincided with an era of financial market expansion and vast growth in international commerce. Specifically, a sudden expansion of financial liquidity in the world’s leading banking centers — whether an increase in British gold reserves in the 1820s or the massive transformation in the 1980s of illiquid mortgage loans into very liquid mortgage securities, or some other structural change in the financial markets — has been the catalyst behind every period of globalization.
If liquidity expansions historically have pushed global integration forward, subsequent liquidity contractions have brought globalization to an unexpected halt. Easy money had allowed investors to earn fortunes for their willingness to take risks, and the wealth generated by rising asset values and new investments made the liberal ideology behind the rapid market expansion seem unassailable. When conditions changed, however, the outflow of money from the financial centers was reversed. Investors rushed to pull their money out of risky ventures and into safer assets. Banks tightened up their lending requirements and refused to make new loans. Asset values collapsed. The costs of globalization, in the form of social disruption, rising income inequality, and domination by foreign elites, became unacceptable. The political and intellectual underpinnings of globalization, which had once seemed so secure, were exposed as fragile, and the popular counterattack against the logic of globalization grew irresistible.
The big bang
The process through which monetary expansions lead to economic globalization has remained consistent over the last two centuries. Typically, every few decades, a large shift in income, money supply, saving patterns, or the structure of financial markets results in a major liquidity expansion in the rich-country financial centers. The initial expansion can take a variety of forms. In England, for example, the development of joint-stock banking (limited liability corporations that issued currency) in the 1820s and 1830s — and later during the 1860s and 1870s — produced a rapid expansion of money, deposits, and bank credit, which quickly spilled over into speculative investing and international lending. Other monetary expansions were sparked by large increases in U.S. gold reserves in the early 1920s, or by major capital recyclings, such as the massive French indemnity payment after the Franco-Prussian War of 1870, the petrodollar recycling of the 1970s, or the recycling of Japan’s huge trade surplus in the 1980s and 1990s. Monetary expansions also can result from the conversion of assets into more liquid instruments, such as with the explosion in U.S. speculative real-estate lending in the 1830s or the creation of the mortgage securities market in the 1980s.
The expansion initially causes local stock markets to boom and real interest rates to drop. Investors, hungry for high yields, pour money into new, nontraditional investments, including ventures aimed at exploiting emerging technologies. Financing becomes available for risky new projects such as railways, telegraph cables, textile looms, fiber optics, or personal computers, and the strong business climate that usually accompanies the liquidity expansion quickly makes these investments profitable. In turn, these new technologies enhance productivity and slash transportation costs, thus speeding up economic growth and boosting business profits. The cycle is self-reinforcing: Success breeds success, and soon the impact of rapidly expanding transportation and communication technology begins to cause a noticeable impact on social behavior, which adapts to these new technologies.
But it is not just new technology ventures that attract risk capital. Financing also begins flowing to the “peripheral” economies around the world, which, because of their small size, are quick to respond. These countries then begin to experience currency strength and real economic growth, which only reinforce the initial investment decision. As more money flows in, local markets begin to grow. As a consequence of the sudden growth in both asset values and gross domestic product, political leaders in developing countries often move to reform government policies in these countries — whether reform consists of expelling a backward Spanish monarch in the 1820s, expanding railroad transportation across the Andes in the 1860s, transforming the professionalism of the Mexican bureaucracy in the 1890s, deregulating markets in the 1920s, or privatizing bloated state-owned firms in the 1990s. By providing the government with the resources needed to overcome the resistance of local elites, capital inflows enable economic-policy reforms.
This relationship between capital and reform is frequently misunderstood: Capital inflows do not simply respond to successful economic reforms, as is commonly thought; rather, they create the conditions for reforms to take place. They permit easy financing of fiscal deficits, provide industrialists who might oppose free trade with low-cost capital, build new infrastructure, and generate so much asset-based wealth as to mollify most members of the economic and political elite who might ordinarily oppose the reforms.
Policymakers tend to design such reforms to appeal to foreign investors, since policies that encourage foreign investment seem to be quickly and richly rewarded during periods of liquidity. In reality, however, capital is just as likely to flow into countries that have failed to introduce reforms. It is not a coincidence that the most famous “money doctors” — Western-trained thinkers like French economist Jean-Gustave Courcelle-Seneuil in the 1860s, financial historian Charles Conant in the 1890s, and Princeton University economist Edwin Kemmerer in the 1920s, under whose influence many developing countries undertook major liberal reforms — all exerted their maximum influence during these periods. During the 1990s, their modern counterparts advised Argentina on its currency board, brought “shock therapy” to Russia, convinced China of the benefits of membership in the World Trade Organization, and everywhere spread the ideology of free trade.
The pattern is clear: Globalization is primarily a monetary phenomenon in which expanding liquidity induces investors to take more risks. This greater risk appetite translates into the financing of new technologies and investment in less developed markets. The combination of the two causes a “shrinking” of the globe as communications and transportation technologies improve and investment capital flows to every part of the globe. Foreign trade, made easier by the technological advances, expands to accommodate these flows. Globalization takes place, in other words, largely because investors are suddenly eager to embrace risk.
The big crunch
As is often forgotten during credit and investment booms, however, monetary conditions contract as well as expand. In fact, the contraction is usually the inevitable outcome of the very conditions that prompted the expansion. In times of growth, financial institutions often overextend themselves, creating distortions in financial markets and leaving themselves vulnerable to external shocks that can force a sudden retrenchment in credit and investment. In a period of rising asset prices, for example, it is often easy for even weak borrowers to obtain collateral-based loans, which of course increases the risk to the banking system of a fall in the value of the collateral. For example, property loans in the 1980s dominated and ultimately brought down the Japanese banking system. As was evident in Japan, if the financial structure has become sufficiently fragile, a retrenchment can lead to a collapse that quickly spreads throughout the economy.
Since globalization is mainly a monetary phenomenon, and since monetary conditions eventually must contract, then the process of globalization can stop and even reverse itself. Historically, such reversals have proved extraordinarily disruptive. In each of the globalization periods before the 1990s, monetary contractions usually occurred when bankers and financial authorities began to pull back from market excesses. If liquidity contracts — in the context of a perilously overextended financial system — the likelihood of bank defaults and stock market instability is high. In 1837, for example, the U.S. and British banking systems, overdependent on real estate and commodity loans, collapsed in a series of crashes that left Europe’s financial sector in tatters and the United States in the midst of bank failures and state government defaults.
The same process occurred a few decades later. Alphonse Rothschild’s globalizing cycle of the 1860s ended with the stock market crashes that began in Vienna in May 1873 and spread around the world during the next four months, leading, among other things, to the closing of the New York Stock Exchange (NYSE) that September amid the near-collapse of American railway securities. Conditions were so bad that the rest of the decade after 1873 was popularly referred to in the United States as the Great Depression.
Nearly 60 years later, that name was reassigned to a similar episode — the one that ended the Roaring Twenties and began with the near-breakdown of the U.S. banking system in 1930–31. The expansion of the 1960s was somewhat different in that it began to unravel during the early and mid-1970s when, thanks partly to the OPEC oil price hikes and subsequent petrodollar recycling, a second liquidity boom occurred, and lending to sovereign borrowers in the developing world continued through the end of the decade.
However, the cycle finally broke down altogether when rising interest rates and contracting money engineered by then Federal Reserve Chairman Paul Volcker helped precipitate the Third World debt crisis of the 1980s. Indeed, with the exception of the globalization period of the early 1900s, which ended with the advent of World War I, each of these eras of international integration concluded with sharp monetary contractions that led to a banking system collapse or retrenchment, declining asset values, and a sharp reduction in both investor risk appetite and international lending.
Following most such market crashes, the public comes to see prevalent financial market practices as more sinister, and criticism of the excesses of bankers becomes a popular sport among politicians and the press in the advanced economies. Once capital stops flowing into the less developed, capital-hungry countries, the domestic consensus in favor of economic reform and international integration begins to disintegrate. When capital inflows no longer suffice to cover the short-term costs to the local elites and middle classes of increased international integration — including psychic costs such as feelings of wounded national pride — support for globalization quickly wanes. Populist movements, never completely dormant, become reinvigorated. Countries turn inward. Arguments in favor of protectionism suddenly start to sound appealing. Investment flows quickly become capital flight.
This pattern emerged in the aftermath of the 1830s crash, when confidence in free markets nose-dived and the subsequent populist and nationalist backlash endured until the failure of the much-dreaded European liberal uprisings of 1848, which saw the earliest stirrings of communism and the publication of the Communist Manifesto. Later, in the 1870s, the economic depression that followed the mass bank closings in Europe, the United States, and Latin America was accompanied by an upsurge of political radicalism and populist outrage, along with bouts of protectionism throughout Europe and the United States by the end of the decade. Similarly, the Great Depression of the 1930s also fostered political instability and a popular revulsion toward the excesses of financial capitalism, culminating in burgeoning left-wing movements, the passage of anti-bank legislation, and even the jailing of the president of the NYSE.
Profits of doom
Will these patterns manifest themselves again? Indeed, a new global monetary contraction already may be under way. In each of the previous contractions, stock markets fell, led by the collapse of the once-high-flying technology sector; lending to emerging markets dried up, bringing with it a series of sovereign defaults; and investors clamored for safety and security.
Consider the crash of 1873, a typical case: Then, the equivalent of today’s high-tech sector was the market for railway stocks and bonds, and the previous decade had seen a rush of new stock and bond offerings that reached near-manic proportions in the early 1870s. The period also saw rapid growth of lending to Latin America, southern and eastern Europe, and the Middle East. Wall Street veterans had expressed nervousness about market excesses for years leading up to the crash, but the exuberance of investors who believed in the infinite promise of the railroads, at home and abroad, coupled with the rising prominence of bull-market speculators like Jay Gould and Diamond Jim Brady, swept them aside. When the market collapsed in 1873, railway securities were the worst hit, with many companies going bankrupt and closing their doors. Major borrowers from the developing world were unable to find new financing, and a series of defaults spread from the Middle East to Latin America in a matter of months. In the United States, the Congress and press became furious with the actions of stock market speculators and pursued financial scandals all the way to President Ulysses S. Grant’s cabinet. Even Grant’s brother-in-law was accused of being in cahoots with a notorious group that attempted a brutal gold squeeze.
Today, we see many of the same things. The technology sector is in shambles, and popular sentiment has turned strongly against many of the Wall Street heroes who profited most from the boom. Lending to emerging markets has all but dried up. As of this writing, the most sophisticated analysts predict that a debt default in Argentina is almost certain — and would unleash a series of other sovereign defaults in Latin America and around the world. The yield differences between risky assets and the safest and most liquid assets are at historical highs. In short, investors seem far more reluctant to take on risk than they were just a few years ago.
This lower risk tolerance does not bode well for poor nations. Historically, many developing countries only seem to experience economic growth during periods of heavy capital inflow, which in turn tend to last only as long as the liquidity-inspired asset booms in rich-country financial markets. Will the international consensus that supports globalization last when capital stops flowing? The outlook is not very positive. While there is still broad support in many circles for free trade, economic liberalization, technological advances, and free capital flows — even when the social and psychic costs are acknowledged — we already are witnessing a strong political reaction against globalization. This backlash is evident in the return of populist movements in Latin America; street clashes in Seattle, Prague, and Quebec; and the growing disenchantment in some quarters with the disruptions and uncertainties that follow in the wake of globalization.
The leaders now gathered in opposition to globalization — from President Hugo Chávez in Venezuela to Malaysian Prime Minister Mahathir bin Mohamad to anti-trade activist Lori Wallach in the United States — should not be dismissed too easily, no matter how dubious or fragile some of their arguments may seem. The logic of their arguments may not win the day, but rather a global monetary contraction may reverse the political consensus that was necessary to support the broad and sometimes disruptive social changes that accompany globalization. When that occurs, policy debates will be influenced by the less emotional and more thoughtful attacks on globalization by the likes of Robert Wade, a professor of political economy at the London School of Economics, who argues forcefully that globalization has actually resulted in greater global income inequality and worse conditions for the poor.
If a global liquidity contraction is under way, antiglobalization arguments will resonate more strongly as many of the warnings about the greed of Wall Street and the dangers of liberal reform will seem to come true. Supposedly irreversible trends will suddenly reverse themselves. Further attempts to deepen economic reform, spread free trade, and increase capital and labor mobility may face political opposition that will be very difficult to overcome, particularly since bankers, the most committed supporters of globalization, may lose much of their prestige and become the target of populist attacks following a serious stock market decline. Because bankers are so identified with globalization, any criticism of Wall Street will also implicitly be a criticism of globalizing markets.
Financiers, after all, were not the popular heroes in the 1930s that they were during the 1920s, and current events seem to mirror past backlashes. Already the U.S. Securities and Exchange Commission, which was created during the Great Depression of the 1930s, is investigating the role of bankers and analysts in misleading the public on the market excesses of the 1990s. In June 2001, the industry’s lobby group, the Securities Industry Association, proposed a voluntary code, euphemized as “a compilation of best practices… to ensure the ongoing integrity of securities research and analysis,” largely to head off an expansion of external regulation. Increasingly, experts bewail the conflicts of interest inherent among the mega-banks that dominate U.S. and global finance.
Globalization itself always will wax and wane with global liquidity. For those committed to further international integration within a liberal economic framework, the successes of the recent past should not breed complacency since the conditions will change and the mandate for liberal expansion will wither. For those who seek to reverse the socioeconomic changes that globalization has wrought, the future may bring far more progress than they hoped. If global liquidity contracts and if markets around the world pull back, our imaginations will once again turn to the increasingly visible costs of globalization and away from the potential for all peoples to prosper. The reaction against globalization will suddenly seem unstoppable.
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In re-reading the article it is clear that I was a little premature. I expected that we were just two or three years away from the big global contraction, when in fact it was nearly six years away. The “Greenspan put” was once again exercised and the market bailed out, but as Hyman Minsky would probably have pointed out had he been alive, this would only ensure that the crisis, when it eventually came, would be worse. By preventing the market from adjusting to the imbalances generated in the 1990s, policymakers effectively forced the financial system to adjust by taking on even more risk, just as Minsky described.
As the students in my central bank seminar at Peking University discussed in class last week, Minsky’s analysis has important implications for China. It suggests that every time Beijing takes steps to prevent financial volatility, they may simply be forcing the banking system to ratchet up the risk. Eventually it becomes very hard to prevent the system from clearing anyway, but it does so with a much greater amount of risk embedded in the system.
At any rate the key point is that changes in risk appetite, which are often driven by changes in underlying liquidity, have a number of important balance sheet consequences. During the period of rising liquidity it may be easy to ignore those consequences, especially since rising asset prices and cheap liquidity obscure the risks, but when the contraction comes, as it always must, we are often surprised by the range of conditions that change and how dramatic that changes can be.
Very educative Mr. Pettis, specially for people who are ignorants in economic history, like me. I would like you to extend a bit more in the commentary. If Minsky is rigth and the longer you allow imbalances to linger the more disruptive is the clearing I would like you to comment on recent edevelopments:
1) China. It has been reported las week that the authorities introduced reforms in the financial system in order to reduce bank margins in favour of deposit holders (households in general I suppose). That goes in the correct direction by reducing finantial repression is in China but will surely cause disruption in financial entities. Do you think that this was a good move even if banks perceive greater risks with less margin?
2) Spain. The government has recently agreed a 100.000 million rescue for the spanish banks that will allow the financial system to survive for some more time. Some time has been bougth. In my opinion, it will be used to go on the austerity path, but will not be used to force bank restructuring, and we may will end with a bigger problem a few months after the rescue. What would you recommend to the spanish government to do with these “extra months” gained to solve the crisis?
Any comment on John Hempton’s piece on the kleptocracy in China, in part driven by financial repression and the one-child policy?
Aloha Professor Pettis,
Quote from article…
“The costs of globalization, in the form of social disruption, rising income inequality, and domination by foreign elites, became unacceptable. The political and intellectual underpinnings of globalization, which had once seemed so secure, were exposed as fragile, and the popular counterattack against the logic of globalization grew irresistible.”
This statement made me think. What is the point of global investment, when it causes such social disruption? Does the thrill of risk and profit obscure social disruption?
In the past, there always seemed to be another area to keep expanding investment… another country, another undeveloped territory, another untouched beach. Those areas are running short now.
So now after centuries of very intense global investment, are we heading toward a “tragedy of the commons” where we are over-exploiting common resources? The financiers still make profits but the environmental, social and cultural costs build higher and higher and those costs get distributed away from the investors to the people in general.
When the next global expansion comes, whether with a technological advance or not, there is now much more global money that would want to participate. The expansion would have to be that much greater, because so many investors would push into it (changing laws, ideologies and institutions to justify their risks for profit)… and we would move even closer to a global tragedy of the commons.
How have you figured into your insights the “tragedy of the commons” scenario (where mounting social costs get imposed)?
There is a chicken-vs-egg argument here. Game changing technology, that leads to investment, that leads to innovation, that leads to levered investment, that leads to monetary expansion, that leads to globalization, that leads to trade imbalance, that leads to … etc … leads to protectionism …. austerity … contraction.
Its hard to separate cause from effect with money and production. I say that without products (labor,technology) there is no need for money (medium of exchange, store of value), so product must necessarily be first. Whatever, its an arbitrary position.
The philosophical point of your article seems to be that monetary expansion/ contraction and globalization/ localization alternate cyclically and that the patterns are recognisable enough that you were able to convert obsevations into an early call for the coming contraction.
So whats next? How far down does the ship sink? How long does it take? Is there a fast way to get through the bottom? If you had compromising photographs of central planners from China, Japan, the US and Germany at a wild WTO afterparty what would command them to do?
Mr. Pettis,
Paul Krugman is wondering what you think:
http://krugman.blogs.nytimes.com/2012/06/11/financial-repression-chinese-style/
This is an eerily prescient analysis with respect to the backlash against bankers and the rise of populism/nationalism. I would be curious to hear your thoughts about how capital flows contributed to the most recent cycle as compared to the historical examples you describe. It seems to me that China’s positive current account balance during the buildup to 2007 makes this case somewhat different. Granted, there was a huge amount of fixed investment in China, but it seems to have been funded largely through domestic financial repression rather than foreign investment. The “emerging market” bubble in this case was developed-market real estate aided by a reckless dose of financial “innovation”.
Thank you for reposting this article and for your continued insightful analysis.
Ignacio@1
When a serious economist forgoes listening to YO-YO Ma and takes up listening
to local punk groups you know that economic crises is not an event but prolonged
severe depression which he seeks to escape from thinking or analyzing.
Prof Pettis
I read your articles regularly and quite enjoy it. Hope you take this lightly but you are becoming grunge economist with this! Time to make a round to Seattle.
Hi Prof,
What is different about globalization now is the role of governments in distorting the fundamentals such as interest rates and exchange rates. Whereas the exchange rates are not directly manipulated in the west, the interest rates certainly are. Every major economy that has one way or the other ensured cheap money has gained advantage in trade. Wouldn’t you consider the globalization crisis as an indirect effect of these manipulations? And as corollary would it help if interest rates were allowed to be determined entirely by market forces (I am not sure how this can be affected in practice)? One could argue that market determined interest (and exchange) rates would lead to constant, dynamic adjustments in prices, whether in internal or external trade, and thereby prevent large distortions from building up.
I can’t help but think that this contraction will be worse than past ones by the very fact that liquity (capital flows) can respond much faster than in the past. Speed itself, as in biological neural networks, is a factor in its own right.
Dr. Pettis,
I understand your very reasonable reasons for being for the liberalization of trade. However, as you mentioned, there are serious arguments against as well.
On the side of being (luke warmly) against global trade, I feel that:
1. Globalization is a pro-cyclical phenomena. It’s better that some economies are growing & others are shrinking rather than them all growing & shrinking together.
2. All of this shipping products across the globe isn’t very efficient and has environmental impacts that should be avoided.
3. Like the EZ, there is no real (strong) sovereign world governing body. Countries are allowed to game the system (for example, using mercantilist policies to steal growth) and unregulated capital flows are pro-cyclical.
I could go on, but you see my point. Can you comment on how create a better way that leads to a more balanced (anti cyclical) world trade system, encourages sefl-sufficiency where it makes sense while allowing trade where that makes sense as well (the Swiss making watches, for example)
One last thing, I am really sad you removed me from your mailing list. I guess my email asking if China might turn to militarism to stoke its economy was unwelcome. If you did add me back, I will promise to be good, no more unsolicited emails. I really looked forward to those emails and miss them dearly.
Thanks,
- someone who has learned a great deal from your writings
It was good to read your quote in ‘TIME” magazine this week, talking about the chinese economy. Finally they talk about what you’ve been saying for the last couple of years…
Have you heard about the book “This time is different”? If so, do you think it’s worth reading?
Thanks
We might be better off listening to one of Hyman Minsky’s students, Professor Randolph Wray at UMKC. ‘Modern Monetary Theory’ has a lot of sensible things to say about the capabilities of modern fiat monetary systems to achieve policy goals of ‘full employment and price stability’. Of course even if these principles became better understood and accepted there is no guarantee that people will use them.
One example: The obvious fact that there was a huge speculative real-estate boom in the US, driven largely by fraud (even a non-economist like myself recognized this years before the crisis), did not cause the ‘genius’, Alan Greenspan (then Chair of the Federal Reserve) to take action to prevent it from turning into the catastrophe it became.
Ignacio, on point one I think you ask the right question. Reducing the margins won’t help the household sector if banks have insufficient capital to cover NPL losses since those losses eventually work their way back to the household sector. This is just an additional reason why it is important to raise the lending rate. As for your second point, if you believe, as I do, that it is almost inevitable that Spain leave the euro, then the sooner it happens the less painful for Spain.
Phillip, some of what he says makes sense but I think it is a little extreme and it is pretty clear he doesn’t understand the causes of high savings in China. He confuses personal savings with national savings.
Edward, I never tried to suggest that it is global investment that causes social disruption. My argument is that the process of globalization, with its booming asset markets, can often hide real problems in social, political and economic institutions that only become obvious during the period or retrenchment.
Kevin, it is not a chicken-and-egg problem so much as it is a problem of systematic self-reinforcement, which by the way is quite common in finance and economics and is always likely to exacerbate volatility. I have discussed many times in previous postings what I think needs to be done, but to simplify dramatically all the major imbalances will rebalance one way or the other and the point is to recognize that the only real options for policymakers are between less painful rebalancing and more painful rebalancing. Polices that attempt to postpone rebalancing simply won’t work.
Bill, most previous cases of investment-driven growth “miracles” were funded domestically, at least for large economies. Even Brazil was largely domestically funded until it started running into debt capacity limits in the mid-1970s, and so turned to the suddenly booming petrodollar market to keep the party going a few more years.
Stan, of course you are right. Anyone whose cultural tastes aren’t solidly and unimpeachably middle-brow should be ignored.
Kivahur, actually in both the 1920s and 1960 there were significant distortions in monetary policy and interest rate regimes. I don’t think the latest cycle was unique in that sense.
Glen, yes, according to the chaos theory stuff that was fashionable in the 1990s friction is stabilizing, and eliminating friction can make chaotic systems less stable. Plentiful liquidity that can speed quickly and cheaply around the world may markets more volatile.
DaveG, as I try to show in my next book it is very hard to prevent players from gaming the trading system, but Minsky would have probably argued that the best bet is to put into place institutions that embed countercyclical behavior in their balance sheets. The problem is that when thing are going well it is very hard to convince anyone to do so since in the boom countercyclical mechanism are money losers. During a crisis we want our leaders to have purchased insurance, but during the boom we punish them if they do. By the way, I did not bump you from the newsletter list. I am not sure why but sometimes subscribers do not get the newsletters when they are sent out, but you should get one soon.
Marcos, it is a good book that summarizes a lot of lessons from financial history, but I think it is better if you read widely in financial history so that you have a more granular sense of these crises. Part of the problem is that when you look at the crises individually you see how shaky some of the averages are. For example many readers have concluded from the book that sovereign debt to GDP below 90% is fine but above 90% you begin to run into problems. This, of course, is nonsense. The structure of the debt and the underlying economy, along with the external environment, are all crucially important in deciding what is too much debt. A number like “90%” has almost no informational value at all.
SteveK9, I don’t think it is at all meaningful to say that “there was a huge speculative real-estate boom in the US, driven largely by fraud.” A rise in fraud tends to be a symptom, not a cause, of the late stages of a credit-driven asset boom. In the 1930s Irving Fisher wrote about this same thing
“The public psychology of going into debt for gain passes through several more or less distinct phases: (a) the lure of big prospective dividends or gains in income in the remote future; (b) the hope of selling at a profit, and realizing a capital gain in the immediate future; (c) the vogue of reckless promotions, taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud, imposing on a public which had grown credulous and gullible.
“When it is too late the dupes discover scandals like the Hatry, Krueger, and Insull scandals. At least one book has been written to prove that crises are due to frauds of clever promoters. But probably these frauds could never have become so great without the original starters of real opportunities to invest lucratively. There is probably always a very real basis for the “new era” psychology before it runs away with its victims. This was certainly the case before 1929.”
Michael,
Thanks for your answer. I agree that Spain would do better exiting the euro but when I talk with friends, too many of them believe that an euro exit is the end of the world for Spain and consider it unfeasible. Their arguments are that an euro exit is equivalent to chaos and would imply the end of international confidence in Spain. I find those ideas striking because they reflect that those people don’t have any confidence in the ability of the spanish government (any national government) to deal with the crisis. It seems also that these guys feel better being tutored by the IMF, the BCE or, let’s say, Merkel and do not have much faith in democracy. The other point they make is that Spain depends a lot on foregin capital, but it is precisely the euro what provokes capital fligth out of Spain these days. When we were feeling the euphoria of the housing bubble I did not feel happy about that, but now it is much sadder to see how people has turned the opposite and we are not only dismantling the bubble but many other things that were beneficial for the country. Dismantling research, education or health seems to be good ideas for the sake of our precious balance sheets.
Prof. Pettis:
I know that the bubble is created by inflow of capital and some of the wealth
is transferred to various participants . Is the bubble consists of pure capitol inflow?
or some of bubble is froth that dissipates with economic contraction?
P. S. Sorry for my previous comment. So far I learned my all economics from you.
Michael,
Thank you for the illuminating article on Globalization.
I have one question though, As I understand, Globalization is Just a natural extension of Capitalism, capitalism crossing the sovereign borders of a country.
Capitalism stands on making (and if possible maximising) profits based on future oppurtunities which come along with their own inherent risks. I thought that Capitalism survived on transperancy (unlike other ideologies which have drawn most of thier power through opaqueness of information), but I see the recent recessions as part of decling transperancy in global finances and financial institutions. Isn’t this the simple reason why Globalization has faced such serious challenges (even historically)? why would a small investor continue to pump money into a project when he knows it is hugely risky even though it is from easy money (he should eventually pay it, right) ?
Every country has its own threshold limit of Fiscal Deficit, debt and inflation beyond which the countries suffer serious loss of confidence in themselves and the people themselves become radical (and go against globalization policies) when things go wrong. Isn’t then cultural factors, also, the actual reason why countries end up in recession. Afterall some countries cross debt limits but remain confident while some just collapse even with half the debt than the former. So I think its not exactly possible to have a standard bar (a global regulatory agency) for everybody and anybody who crosses the line set by such global institution will be tagged with financial impropriety, but we can atleast make the people aware on where they stand (for their investment and country’s economic indices).
Also, Somehow I believe that although there are periods of boom where we cannot control the availability of easy money, the global (as well as sovereign) institutions have some responsiblity on making people aware of the risks of excessive greed that comes from easy money and the countries can be made aware of it.
Finally Professor, to cut short my point, Although I agree that Globalization is mainly a monetary phenomenon, the success of Globalization for me mainly depends on the transperancy in the flow of money and the country’s cultural values (like perception of risk for the country or say a level of risk that a country or its investors are willing to take, isn’t risk taking a cultural attribute?, there are certain countries which are just not willing to take risks even at the cost of possible loss of GDP) that are eventually driving globalization ahead.
Love to see your opinion on this.
Thanks.
Michael,
What is your definition of free trade?
Globalization and Free Trade are different things. ricardo never wrote about “globalization.” Globalization is actually a fad disguised as a goal in search of a justification but without a definition.
It was interesting to read Dani Rodrick’s book, “The Globalization Paradox.” Every time you turned the page, the implicit definition of “globalization” seemed to change. It was like watching Marty Feldman in the Mel Brooks Comedy “Young Frankenstein.” He played a hunchback whose hump moved from one side the the next in every scene. Same thing with Rodrick in “the Globalization Paradox. You are never sure which definition of “globalization” he was talking about on any given page.
Sometimes it was free trade in goods, sometimes free trade in services, or free movement of capital, or free movement of labor, or unified regulation, or global governance, etc.
When a word has so many meanings, it has no meaning. It’s a cross between a slogan and an academic fad. It’s an excuse for universities to accept donations to form prestigious new schools of “International Law” and service.
And business likes globalization because it’s a great way to justify regulatory arbitrage. “Don’t even think of taxing or regulating us,” they scream, “or we will go somewhere else to create jobs where they don’t mind a little arsenic in the river water.”
Michael — If a word communicates nothing, why can’t we drop it?
Sorry, I meant to begin my last post by asking: “What is your definition of globalization?”
Mr. Pettis,
Do you think the Fed will ultimately be successful pumping up global liquidity? The ECB will also likely pump more Euros into the global market as part of sovereign or bank bailouts and increasing money supply. Won’t these actions at some point move the global economy and reignite capital flows to developing countries? The Money Center Banks’ balance sheet problems are muting the Fed’s actions, but at some point this money will catch fire and find it’s way into the global economy. The velocity of money will eventually increase.
I have friends who played the rise in commodities in 2009 who argued gold and silver must go even higher. I told them this might happen due to economic instability, but inflation will not be a threat for several years. My argument was the world was awash with supply (both labor and capital) and global competition from Asia was driving/keeping wages and prices down. The answer was for the Fed to pump Dollars into the global economy. This would fight deflation here and abroad.
These actions by the Fed (and the ECB) will not only benefit global liquidity, but they will also make U.S. and European products, services, tourism and real estate cheaper relative to the rest of the world. Anectodally, the Asians and Latin Americans are buying more U.S. property (California, Miami, etc.) and increasing visits to the U.S. At the beginning of the recession, the U.S. and much of Europe was priced expensively. This also has forced China’s hand to move towards internal rebalancing as they are painfully aware the Fed is ultimately devaluing China’s Dollar holdings (regardless of how it is expressed in managed exchange rates).
Consistent with your writings, increasing the supply of dollars would seem to be one of the necessary actions for remedying the global economy’s ills. Are we to expect more pain around the world as the global economy rebalances before we can expect this remedy to take hold?
Michael — You analyze the world through the lens of science, technology, commerce, finance, politics, and culture, and wrongly claim that commerce and finance are always the drivers of globalization.
That is the wrong lens. You must look through the lens of morality to understand the aggregate evolutionary growth spurts of humanity.
This is not a financial crisis, this is a moral crisis.
The reality is that science and technology, practiced in periods of greatest freedom of the human spirit, create products that in their aggregate morality tend to better the aggregate social organism. Commerce and finance are morally parasitic forces that always first promise a fair distribution of these more socially beneficial scientific and technological products that are created but in the end their parasitic drag always becomes extreme and the effect is that they serve to reduce the aggregate morality of humanity.
The invention of radio was parasitically co-opted by the wealthy elite through corruption of the ‘rule of law’ and turned into a powerful culture shaping propaganda tool. Similarly, socially beneficial TV and all other media were co-opted and re-purposed for culture shaping propaganda that has created a wealth adoring culture that now accepts as normal that “greed and evil are good”. The internet is now under a similar relentless attack.
Again; this is not a financial crisis, this is a moral crisis.
All of life is politics — it is all about getting needs met (perceived or real).
The growth spurts, they are not cyclical, always rectify, resolve, and re-balance through a chaotic process, where the parasitic forces of Evilism (Vanilla Greed for Profit) mutate into Xtrevilism (Parasitic Greed for Control) and then the resolution takes place. The danger now, as opposed to your early 1865 sample, is that the co-opted science and technology now has the power to destroy us all.
It is time to get out of the confining little boxes.
We need to begin talking in terms of morality and GWH — Gross World Happiness.
http://www.boxthefox.com/
Deception is the strongest political force on the planet.
Michael: You have confused cause and effect. The explosion of joint stock company financings in the 1820s in Britain was in response to the opportunities for obscene profit which the new, improved steam engine technology offered. The boom was as much in steamships as it was in railroads. Much of the canal mania that occurred in the U.S. and Europe at that time can be explained by the fact that canal boats could power themselves and were no longer dependent on horses to pull them. The comments about the Panic of 1873 are badly inaccurate. There was no explosion of private finance after the Civil War; the expansion of credit came almost entirely from the need of the Federal Treasury to refinance the debts incurred during the Civil War. The rise and fall of Jay Cooke can be attributed almost entirely to his bet that he could sell private securities with the same ease that he sold government bonds. He couldn’t; and his firm collapsed when he had to eat his inventory of railroad securities. Grant’s alleged “corruption” was, in fact, the opposite; by insisting that the country return to the gold standard, Grant threatened the speculation that the government would continue more greenbacks. Gould and Brady were seeking a corner in gold on the assumption that the government would do what it did in the 1930s and hoard gold by refusing to pay out specie. Grant did the exact opposite; he not only required the Treasury to continue to pay out gold to meet all obligations but also insisted that the Civil War greenbacks also be redeemed. The result was a sharp and severe panic based on the collapse of inflation speculation followed by a period of the greatest growth in personal and business incomes that the country has ever experienced.
Dear Mr Pettis,
Very brilliant post, as usual. You make some of us realize the depth our ignorance (which is a good start). When we look at the level of debt accumulation around the world, it looks like the coming crunch will be nail biting. I guess one should buy a basket of tobacco shares, short the Nasdaq and a few emerging markets and wait and make sure about the counterparty risk.
LetUsHavePeace, I think your reading of history is, at best, eccentric. I won’t go into it all because there is too much to dispute, so I will simply address your description of the 1873 crisis, which makes no sense at all (and for many of the same reasons as your description of the process in the 1820s).
The 1873 crisis actually began in May 1873 in Vienna and spread to the rest of Europe and even parts of Latin America, only getting to NY by September, which makes it a little odd to claim that the collapse of J Cooke & Co. was the cause, rather than one of many symptoms, of the bubble and its deflation. In fact Cooke participated in a frenzy of railroad building that was clearly excessive and was both a consequence of the global liquidity expansion and part of its deflation after 1873. After all it was not just the Northern Pacific that collapsed, and it was not just in the US that there was a railroad bubble. You are guilty of a very bad case of what logicians call the “post hoc ergo propter hoc” fallacy, and, what is worse, you see history as a purely domestic issue and fail to see the sometimes very obvious global links. The 1873 crisis was not a US crisis; it was global crisis, and so any explanation that limits itself to what happened only in New York, or London, or Vienna, or Berlin, or Buenos Aires, is almost certainly wrong.
Finally you are completely wrong in your understanding of the corruption scandals in Grant’s cabinet. It wasn’t Grant who was accused of corruption, but rather many of his closest advisors and cabinet members, and I believe his brother-in-law was actually indicted for his role in Gould’s gold squeeze. His Secretary of War was impeached by the House. There was a lot more to corruption in the Grant White House than a mistaken “allegation”, and this is hardly controversial among historians.
Guilty. Almost all of the histories of the 19th century booms and busts written by modern economists presume that money and credit were as indistinguishable from one another as they have become in the age of central banking. Some of us find comparisons between the present age and one in which only specie was money and everything else – even the Bank of England’s notes – were considered forms of credit questionable, even if it is the current conventional academic opinion. As for Belknap, his arranging for his second wife to share half the profits from the Fort Sill Indian agency, was wrong; but it hardly measures up to our modern standards of corruption. There is, in fact, very much of a controversy among present historians about the accusations against the two Grant Administrations; many scholars of the younger generation is beginning to share our amateur opinion that Grant’s accusations of corruption came from two sources: (1) the embittered Abolitionists like Sumner who wanted a Carthaginian peace imposed on the South, and (2) the Southern Democrats who were infuriated by Grant’s insistence that the Constitution’s most recent Amendments be fully honored.
Globalization is the devaluation of passive capital in response to technological shift.
Professor, your thesis is almost correct, but as far I can see, you may have missed a very important cause and effect relationship.
I have got it all figured it out now.
Agreed.
My thesis is that the monetary expansion is caused by technological shifts (not the other way around as you have it), via the mechanism where the majority of the population has been reduced in relative knowledge value w.r.t. to the knowledge producers of those technological shifts. Thus all forms of passive capital have to be devalued, and the most expedient political mechanism for such adjustment is monetary expansion.
The proof is thatnew (as opposed to existing) knowledge production can not be acquired with money nor finance:
http://www.zerohedge.com/news/2012-11-04/bitcoin-seen-through-eyes-central-banker#comment-2951089
http://www.coolpage.com/commentary/economic/shelby/Demise%20of%20Finance,%20Rise%20of%20Knowledge.html#FinanceabilityofKnowledge
Remember on a long enough timeline all persistent borrowers and speculators end up bankrupt. Risk is statistically speaking, another way of saying “devaluation”. I provided quantitative evidence, even for Coca-Cola dividends over 46 years:
http://www.coolpage.com/commentary/economic/shelby/Demise%20of%20Finance,%20Rise%20of%20Knowledge.html#KnowledgeInvesting
In all these cases, you will find that there was some technological shift that caused passive capital to devalue and adjust. These adjustments are painful, because passive capital due its definition is an inherently bankrupt economic model that delays adjustment, as I have explained at the many links in this post.
The technological change doesn’t reverse! Rather the passive capitalism is devalued and there is an adjustment process called “globalization”, which is really just the technological destruction of top-down power (and passive capital, nation-states, etc). The top-down power (and its masses of dependents) tries to consolidate by retreating to greater economies-of-scale, i.e. greater centralization, e.g. supranational institutions.
The result is increased fragmentation by decreasing the size of the fragment closer to the individual (e.g. the combustion engine or the personal computerization), while the passive capital gains a greater fragment size, e.g. from tribes to feudals to nations and now heading to world governance. But the top-down control is losing power as its fragment becomes larger.
This is an incredibly important and profound realization!
Please (Ctrl+F in most browsers) search for the word fragment “automat” at each of the following linked posts of mine, to understand how I see that computerization is driving the current global monetary expansion. For example, China is using a Yuan peg monetary expansion to price its manual labor (up to -800%) below the profit margin of automation, thus stalling the onslaught of computerization.
http://www.mpettis.com/2012/10/27/when-the-growth-model-changes-abandon-the-correlations/#comment-18795
http://www.mpettis.com/2012/10/27/when-the-growth-model-changes-abandon-the-correlations/#comment-18823
http://www.mpettis.com/2012/10/27/when-the-growth-model-changes-abandon-the-correlations/#comment-18682
http://www.mpettis.com/2012/10/27/when-the-growth-model-changes-abandon-the-correlations/#comment-18648
But in the meantime, the computerization epoch is accelerating with billions carrying a PC in their hand (Android and Apple’s iOS). See also the discussion of acceleration of computerization development models with the “inverse commons”, “cathedral vs. bazaar”, and “top-down vs. decentralize” at the following links.
http://www.coolpage.com/commentary/economic/shelby/Demise%20of%20Finance,%20Rise%20of%20Knowledge.html#FinanceabilityofKnowledge
http://www.zerohedge.com/news/2012-11-04/bitcoin-seen-through-eyes-central-banker#comment-2951115
http://www.zerohedge.com/contributed/2012-10-18/shipping-news-and-bit-more#comment-2904368
As your quote of Alphonse Rothschild indicated, most people simply can’t see the technology that we see accelerating, and thus they have all the wrong theories about cause and effect. The following links are very entertaining, once you understand the correct cause and effect I explained above.
http://goldwetrust.up-with.com/t182-technology-that-changes-everything#4754
http://www.mpettis.com/2012/10/27/when-the-growth-model-changes-abandon-the-correlations/#comment-18959
http://www.zerohedge.com/news/2012-10-28/charting-undoing-credit-fueled-globalization#comment-2926945
http://www.zerohedge.com/news/2012-10-21/chinese-gold-imports-through-august-surpass-total-ecb-holdings-imports-australia-sur#comment-2908306
http://www.zerohedge.com/news/2012-10-21/chinese-gold-imports-through-august-surpass-total-ecb-holdings-imports-australia-sur#comment-2908534
This is so profound, I am hopeful that you and others will help promote this understanding, as I don’t have the capability to spread such information, as my field (of computer programming and computer science) is rather abstruse and obfuscated from the mainstreams.
Professor, sharing your thesis and allowing blog comments, helped and motivated me to arrive at this understanding. Thank you. You are one of the knowledge producers and you are participating in this new computerized, inverse commons, bazaar is better than cathedral, knowledge age.
The above is probably the apex of my magnum opus polymath-like contribution to the field of economics. So I better get back to programming now.
Correction on the logic.
Note that as *new* knowledge production decreases, then the passive capitalists’ accumulate more *proportion* of global wealth via compounded interest rate, e.g. in the extreme case automation replaces all labor and no one has an income to buy the production but this also drives production and wealth to zero (100% proportion of 0, is still 0).
Monetary expansion can not drive *new* knowledge production, because ingenuity and innovation is not driven by liquidity, but rather by individual creativity and dedication, which has nothing to do with some hard resources capital limitation. If anything, more liquidity distracts more people towards consumption, and away from innovative discipline. This is even more obviously true in the software programming age we are in now, e.g. the Mythical Man Month proves that adding more money, can not increase the rate of productivity in software creation.
We can think of productivity as being the ratio of *new* qualitative knowledge production per tangible measurable of production, since all value-added comes from knowledge production. Since we can’t measure the former, we typically measure the proxy of production per employee, but this isn’t correct as I explain below.
Monetary expansion can drive the adoption of *existing* technology (i.e. existing knowledge), because technology adoption is analogous to the professor’s point about China’s infrastructure being too expensive to be justified by the level of value-added (*new* knowledge production) in the economy. Liquidity can allow many people to have access to technology that they can’t yet justify in terms of their *new* knowledge production capability, i.e. misallocation of capital. For example, multitudes use their smartphone to do mindless and addictive activity of tweeting their every daily action. Note the wireless tower and network build out in the USA is a negative ROI business.
The misallocation can drive *new* “knowledge production” to be misallocated, e.g. too much software development to service mindless activities. Thus in a sense, this isn’t *new* knowledge production, because it is mindlessly misdirected by liquidity. So liquidity can as I alluded earlier misdirect away from *new* knowledge production.
But what causes liquidity to increase? It is because the passive capital can not be returned and the multitudes can not be employed, because the true productivity (as I defined it) is not increasing fast enough. Remember my extreme example of if we automate everything and there is no *new* knowledge production, then there would be no employment and no income to buy the production.
Another possible conclusion is that monetary expansion runs at equivalent to the rate of compound interest, which was shown to be true:
http://www.goldmeasures.co.nz/2008/05/fiat-debt-money-how-it-drives-countries.html
Any (non-misdirected) *new* knowledge production (not the “knowledge” activity driven by liquidity) is not spread uniformly in the society and money expansion can not cause *new* knowledge production. Thus passive capital is not focused on *new* knowledge production (the returns only aggregate with the fewer *new* knowledge producers), thus is not obtaining sufficient ROI to be paid.
So we can’t conclude for sure that *new* knowledge production causes monetary expansion, but we can conclude that monetary expansion devalues passive capital and the multitudes, relative to the fewer true knowledge producers. And we can conclude that if *new* knowledge production was not occurring, then standard-of-living would not be inexorably increasing.
So rather than concluding that *new* knowledge production is causing globalization, we can conclude that *new* knowledge production becomes amplified in relative value coincident with the monetary expansion of globalization.
To summarize my prior 2 comments, globalization is probably spawned by some fundamental technological innovation that increases productive efficiencies, e.g. the combustion engine and most recently the personal computer.
Society then politically misallocates these new efficiencies (via monetary expansion), because they are unevenly spread in the knowledge of the economy. This political theft ends with a crash of the ignorants. The knowledge holders retain their correct worth.
We can then clearly see the role China has played, and how it will crash. See my other comments in later blogs.
Globalization Technology Cycle
Housing Recovery Illusion
Continued inflation-adjusted housing decline due to technological unemployment.
http://www.coolpage.com/commentary/economic/shelby/Housing%20Recovery%20Illusion.html
The first historical chart on the linked page will make you believer that we can get several decades of persistent unemployment from the technological innovation.
http://esr.ibiblio.org/?p=4781&cpage=1#comment-394688
JustSaying wrote:
(Francis Fukuyama, an American political scientist, political economist): “…the excesses of capitalism are a threat to democracy…
“We have had a lot of technological change that substituted for low-skill labor and made many people in Western democracies lose their jobs.
“We have unthinkingly embraced a certain version of globalization that assumed we had to move very quickly into this post-industrial, post-manufacturing world. Doing so, we forgot that the whole reason real socialism never took off in the US was the fact that the modern economy seemed to produce middle-class societies in which the bulk of the population could enjoy a middle-class status. They worked in industries that were abolished in our countries and transferred to countries like China.
“What you are going to see in a democracy with a weaker middle class is much more populism, more internal conflict, an inability to resolve distributional issues in an orderly way.
“The president [Obama] never annunciated a vision of a different kind of economic order that did not just look like a return to a kind of classic big spending, liberal Democratic formula. The Democrats have never articulated an economic philosophy that is not just the return to the 1970s, big government and so forth, or the position of the labor unions which is very hostile to globalization.
“We should never have permitted the Chinese to de-industrialize a large part of the world.
“China is never going to be a global model. Our current Western system is really broken in some fundamental ways, but the Chinese system is not going to work either. It is a deeply unfair and immoral system where everything can be taken away from anyone in a split second, where people die in train accidents because of a rampant lack of public oversight and transparency, where corruption rules. We are already seeing huge protests in all parts of China …
“Liberal democracy still really is the only game in town worldwide, in spite of all of its shortcomings.”
Well said Henrik. I was recently in Canada where I overheard two Canadians discussing the failure of trickle-down economics in the U.S.. We had been talking with them earlier. I told them trickle-down economics worked for China, India, etc. the previous decade.
I agree with many of your points. More populism, Democrats offering big government. Free trade is simply dogma and it has undermined both national objectives and the Western system. We could be proven wrong if China makes progress over the next two decades in political participation and freedoms. China isn’t Russia, but look at Russia over the last twenty years. Political participation and freedom are dubious at best.